The Search for Income

April 1st, 2012

With the Federal Reserve continuing to keep short-term interest rates at close to zero, retirees and investors are faced with the problem of how to generate current income from their investments. The low- interest-rate environment has resulted in money market mutual funds and CDs providing investors with negative rates of return after considering inflation.

BWFA has addressed this problem by looking past bonds to other investments which we expect to produce a reliable income stream. For example, the average current yield for clients invested according to our conservative growth model is currently 2.6%. This means that a portfolio of $1 million will produce $26,000 in cash for distributions. Examples of some stocks we hold for our clients that we believe will provide consistent and growing income streams include Kinder Morgan Partners, LP (KMP), Cal-Maine Foods, Inc. (CALM), Olin Corp. (OLN), and Bristol Meyers Squib Company (BMY). KMP, CALM, OLN, and BMY currently provide yields of 5.6%, 3.4%, 3.7%, and 4.2%, respectively.

Equities for Income

KMP is a pipeline company structured as a master limited partnership (MLP). MLPs are publicly traded partnerships that do not pay income tax as long as the partnership pays out 90% of the current year’s taxable income to investors. We chose KMP because pipeline companies operate stable heavily regulated business activities with strong operating cash flows, critical for providing investors with cash distributions.

CALM is an egg producer with an unusual corporate policy of paying out 1/2 of its earnings each year to shareholders. The dividend has grown 80% over the past 5 years. BMY pays out about 60% of its income and maintains a relatively light debt ratio of about 25%. We recently bought Microsoft Corporation (MSFT) because it provides a yield of about 2.5%, maintains a low level of debt, and held over $50 billion in cash on the balance sheet on December 31, 2011. We also notice that MSFT earns 4 times as much as it pays out, so we should expect to see healthy growth in its dividend.

Dividend growth is an important metric when evaluating equities to generate income. For example, if a company is earning $1 per share, increasing earnings 6% annually, paying a yield of 3%, and distributing 1/2 of its annual earnings to shareholders, the 3% yield remains unchanged. However, the cash dividends will double every 12 years.

And remember, income is only part of a stock’s total return; income + capital appreciation = total return.

What about Bonds and Bond Funds?

The problem, of course, is that bond yields are extremely low; the yield on a ten year Treasury security is now about 2%. In addition, most investors agree that rates are far more likely to increase rather than decrease. When rates increase, the principal value (price) of bonds declines, but the bond payments stay the same. Moreover, because you do not want to sell the bond when the price is down, your liquidity is impaired for the term of the bond.

More importantly, we have observed that many bond funds seeking income have begun to use more risky techniques to try and maintain competitive income payouts to fund holders. We recently sold a fund that was supposed to be a conservative “Ultra Short Term” bond fund after noting that the fund was using futures contracts, foreign bonds, asset-backed bonds, and low-grade corporate bonds to generate higher income. The fund was also leveraging investments using bond futures contracts. In short, we could not adequately assess the fund’s risk. We proceeded to sell the fund and reinvest in another bond fund where we could evaluate the manager’s actions.

We regularly evaluate our stock positions to confirm that company operations remain stable and sustainable. Also, we continue to diligently evaluate the holdings of bond funds to ensure fund managers manage bond portfolios in a transparent manner, which will allow us to properly monitor fund risks.